TED BUTLER COMMENTARY

April 17, 2007

THE DAY OF RECKONING

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

In keeping with a recent theme of publicly responding to reader e-mails, I’d like to address the topic that garners more questions than any other issue, as well it should. The questions revolve around the manipulation that I allege exists in silver. While I try to write about all aspects of the silver market, with a goal of correctly analyzing silver as an investment, it has long been obvious to me that the price of silver has been artificially depressed below what free market forces would dictate. If my allegation that silver is a manipulated market is correct, then it is the most important factor, by far, as nothing could possibly matter more than if a market is free or not.

The questions I receive generally revolve around these issues; What if the COMEX and CFTC just close down the market and declare all open contracts null and void? What if the COMEX does what the LME did in nickel, namely, just declare a contract default? Why can’t the shorts just declare bankruptcy and walk away? What if the shorts have the real silver and are not "naked"? Isn’t silver just like other markets, in that they are all manipulated? Why can’t the manipulation exist forever? Before I answer these questions, I’d like to state my case for manipulation.

For more than 20 years, as I have delved into the inner workings of the silver market and the facts behind the real supply/demand data and the long-term deficit and the resultant disappearing inventories, the one thing always wrong with the picture was the price. Everything fit except the price. For almost 2 decades, production couldn’t keep up with consumption, necessitating the draw down of inventories to the tune of almost 2 billion ounces, yet the price averaged below $5 an ounce. How could that be? Certainly, there were no legitimate free market explanations that I ever encountered that made sense to me.

Either the production and consumption and inventory data were wrong, or the price was wrong. The only explanation that made sense was that "something" was influencing and causing the price to be wrong. That something. I came to discover, was leasing and the outsized concentrated short position, principally on the COMEX division of the New York Mercantile Exchange. Inc. (NYMEX). Since leasing is bascially over as far as new silver supplies are concerned, the only remaining manipulative agent is the concentrated short position. (We will, however, be experiencing the after-effects of leasing and the depleted inventories it caused for a good long time to come).

While prices have, obviously, broken out of the 20 year narrow range over the past few years, to the benefit of long-term silver investors, the short position has remained and has actually grown more concentrated than ever. Thus, I must conclude that the manipulation is still in place. Others would say that the recent years’ price gains alone mean that no manipulation exists. I would readily agree with them if the concentrated short position had also been bought back with the price increase or was delivered against. But that has not occurred.

Some would say the short position doesn’t matter because there is a long position for every short position. That’s flat-out silly. If that were the case, there would be no need for commodity law or enforcement of such law, as there is always a long for every short. History has demonstrated that just because there is a long position for every short position that manipulation is still possible and has, in fact, occurred in many markets, including silver. The net long and short position in every commodity derivatives contract is composed of entirely different entities. It takes one long holder and one short holder to create one contract, but that doesn’t negate or neutralize each entity’s respective contract obligations. So to say there is a long for every short, in terms of that somehow mitigating a potential manipulation, is a statement without substance.

And it’s not just a question of how large the combined long and short position might be. Please read my words carefully. I am not suggesting that silver is manipulated just because a large short position exists (although that is certainly a consideration). I am stating a manipulation exists because a large concentrated short position exists. The key word is "concentrated." Concentration is simply defined as a large and dominant share of one side of the market, long or short, being held by a small number of traders.

More than most market observers, I have first hand experience with allegations of manipulation in an area away from silver (in orange juice). Those allegations of attempted manipulation (later summarily dismissed) centered on a concentrated long position that I was involved in. Although I wish I never had that involvement, there’s something special about first hand and front line experience that sharpens and focuses the mind and teaches lessons not soon forgotten. You learn more from the school of hard knocks than any university or textbook could ever teach you. No pain, no gain. It is from this perspective that I write.

To be sure, there are many who reject my allegations of silver manipulation, particularly in the established financial, mining and regulatory communities. Putting myself in their shoes, I can understand why they would want to reject such allegations, for reasons ranging from embarrassment to liability for missing such a long-term manipulation right under all of our noses. But it really does not matter that they may want to reject even the possibility of a silver manipulation – either there is a silver manipulation or there isn’t.

What matters is what is factual. What is factual is that COMEX silver has a net short position more concentrated and larger, relative to real world supplies and the corresponding concentration of the long-side traders, than any other commodity. What is factual is that there is no compelling or apparent legitimate economic justification for just one, or a couple, or a few traders to hold such a large short position. (If there were such a compelling justification, surely the CFTC or the COMEX would have revealed it). What is factual is that without this concentrated short position the price would be substantially higher. What is factual is that concentration is the prime requirement for manipulation.

Since concentration is mandatory for a manipulation, and since that concentration in silver is documented by the CFTC weekly, in its Commitment of Traders Report, you would think the manipulation in silver would be as obvious as water is wet. The sole reason the CFTC records and publishes the concentration data in every commodity futures contract is precisely to prevent manipulation. There is no other reason. The problem is that the CFTC stops at the publishing function and allows the obvious manipulation to continue, even though their prime mission statement and reason for existence is to guard against manipulation. An observer may ask, how is this possible?

The answer is that this dereliction of regulatory responsibility is par for the course far too often nowadays. Even though taxpayers fund regulatory agencies to the tune of millions and even billions of dollars, sometimes regulators just can’t or won’t do their job. And it’s not just the CFTC asleep at the switch.

For proof of that statement, I’m going to quote from an article that appeared in the Washington Post, on March 14, by Steven Pearlstein, titled, "’No Money Down’ Falls Flat". The article has to do with the developing problems in real estate caused by careless mortgage lending and lax regulation of that lending. Now that problems are evident in real estate and real estate lending, a great stir has been generated in Washington, long after the horse has left the barn. I ask you to read it; keeping in mind the obvious and factual concentrated short position in COMEX silver.

This is how that quote would read if it referred to the silver manipulation –

The simple and common sense question that should be asked of and by the CFTC and all the deniers of the silver manipulation is what would the price of silver be without the concentrated short position? What price would be necessary to attract sufficient numbers of regular and non-concentrated sellers to replace the one or two or few concentrated entities who make up the entire commercial net short position? Obviously, it would take a much higher price to convince long-term investors to part with their silver, or for non-concentrated and non-manipulative shorts to sell and replace the very few present concentrated short sellers.

The big difference between the regulatory negligence in the unfolding real estate lending debacle and the silver manipulation is that there are and were many public and professional voices alerting anyone who would listen of the dangers in real estate. Whereas in silver, I am hard-pressed to come up many public commentators or analysts who point to the documented concentrated short position in COMEX silver. Please don’t misunderstand me – I’m not complaining that I seem to be almost the only public commentator stating the obvious on this issue. When and as this concentrated silver short position gets resolved, being the sole whistleblower is going to be gratifying.

I have to tell you that I am somewhat baffled as to why so few analysts publicly comment on the concentrated silver short position, even after it has been explained to them. To those few analysts that do grasp the significance of this issue, I congratulate you. If there is a more important and overlooked pricing issue regarding silver, then I am hard-pressed to identify that issue.

As of the most recent Commitment of Traders Report for the close of business April 10, the 4 or less largest traders in COMEX silver futures are net short the equivalent of 245 million ounces of silver. This is almost 90% of the total commercial net short position. And I am convinced that one or two traders hold the bulk of this position. Please think about this for a moment. What it means is that the thousands of traders who are collectively net long silver futures are aligned against just one, or two, or a few traders who are short what the thousands are long. This is the epitome of concentration. Try to imagine the price of silver if this one, or two, or a few traders didn’t have such a large short position. Pick a very high price, then triple it.

This concentrated short position is greater than it was at the time I complained to the CFTC last summer, by some 75 million ounces, or 40% more. At that time, the concentrated net short position in COMEX silver futures represented 102 days of global production, towering over the comparable concentrated short position of any other commodity. (The concentrated net short position in crude oil and copper, for instance, is around one days’ production; meaning silver’s concentrated net short position is more than 100 times greater.) Currently, the concentrated silver net short position has grown to 140 days of global production, with no appreciable change in the concentrated net short positions of the other commodities. Clearly, the problem of the concentrated silver net short position is getting worse, not better. But the problem is for the CFTC and the COMEX, it is not a problem for the long-term silver investor.

Here’s a chart (courtesy of Carl Loeb) that depicts the comparative differences in the concentrated short position of various commodities, from last June and today. The attempt is to compare on a true apples vs. apples basis, by converting the concentrated short position into the common denominator of equivalent global days production. I have included COMEX copper, even though the LME has a larger contract, because the LME does not disclose concentration data, to my knowledge. I can assure you that the concentrated short position in COMEX silver towers over any commodity you compare it to. How can this not be manipulation?

The Silver Investor’s Best Friend

As bad as it may be for the regulators and the concept of free markets, the concentrated short position is the long-term real silver investor’s best friend. That’s because no matter how the resolution of this concentrated short position occurs, it will increase the value of real silver. In the end, the concentrated short position must benefit the real silver investor. Let’s see if the answers to the questions asked earlier bear this out.

1. What if the COMEX and CFTC just close down the market and declare all open contracts null and void?

   Let them. All this will do is to destroy the very mechanism that has depressed the price of silver – the ability to short in unlimited quantities. Without that ability to sell short, the price will explode. Further, no futures market would mean all who want to buy, must buy real silver. The sudden combination of no short selling and massive physical buying would send prices to the stratosphere. Of course, futures long holders would be shut out completely.

2. What if the COMEX does what the LME did in nickel, namely, just declare a contract default?

   This would have the same effect as question 1; namely, it would cause buyers to seek out the real thing. The reason the LME was able to pull it off was because there was no prior warning of a possible nickel contract default and no large long position held by the public, whereas in silver, thousands are, and have been, holding long positions for many years. A silver delivery default would be big news, as silver is a world investment asset, unlike nickel. Additionally, such a default in a major US contract market would generate widespread media and legal attention. The default in nickel went virtually unnoticed. That would not be the case in silver.

3. Why can’t the shorts just declare bankruptcy and walk away?

   This is also tantamount to closing the market and default. The result would be no new shorting, increased real buying and skyrocketing prices. And if any individual short tried to employ this action, the exchange would still be liable to the longs due to the clearinghouse structure of guarantees.

4. What if the shorts have the real silver and are not "naked"?

   I hope this is the case, although I doubt it. This would eliminate the probability of a delivery default, but would in no way eliminate the fact that the market has been manipulated. There is a difference between default and manipulation. Just because someone may own large quantities of a commodity does not grant that entity the right to unfairly dominate and control the market price. Commodity law exists to prevent such control and dominance. Besides, if the concentrated shorts did actually deliver the quantities that they are short, that would undoubtedly end their short selling scheme.

5. Isn’t silver just like other markets, in that they are all manipulated?

   Aside from the gold market, I am unaware of any other commodity market where the allegation of manipulation is as persistent as it is in silver. Of course, there are dominant entities in every market, but the documented facts about concentration appear to be unique to silver, particularly when the amounts are compared to real world supplies. This is real simple – if anyone can document a concentrated net short position, held by 4 or less traders, that comes close to the COMEX silver equivalent of 140 days of global production, please let me hear from you.

6. Why can’t the manipulation exist forever?

This question gets asked the most. Like all the other questions, it is a legitimate question to ask. The answer is simple – you can’t control a physical market with paper short sales alone. Sooner or later, physical demand will overwhelm paper transactions. The reason the silver manipulation has lasted as long as it has (20 years) is because the paper short sales were supplemented with physical dumping from leasing. Leasing is done, both from finally being recognized as a failed financial concept and from the more practical limitation that there is no longer inventory to lease. Now it’s down to paper short selling alone, with those sellers struggling to demonstrate adequate physical supplies.

No one can say when the resolution of the highly unique concentrated silver short position will come, just that it must come. The long-term silver investor should root for the resolution to begin at as high a price as possible, because that’s when the real fireworks will start.

Even though the price of silver has climbed dramatically over the past few years, the existence of the concentrated short position is a virtual guarantee that the most exciting upside drama on price is yet to unfold. At some point, this concentrated short position must be closed out. As I have written previously, all short sales are "open" transactions. When you sell something you own, that marks the end or closes that transaction. Nothing else has to be done. When you sell something short, you are selling something that you don’t own, and that leaves the transaction open and to be completed at some future point.

It is not natural or normal for silver, alone among all commodities, to have such an extraordinarily concentrated short position. But that is not a complaint in the sense that it is precisely this extraordinary condition that separates silver from every other commodity in an investment sense. Please put this into perspective – silver has more things going for it than you could imagine, Some of those bullish factors are present in many natural resources, making that asset class my top choice. But the presence of the concentrated short position puts silver in a class on a completely different level than any other commodity.

Here’s an added bonus of the concentrated short position to the silver investor. If there is some macroeconomic development that causes a severe slow down in world economic activity, resulting in less than expected consumption of industrial commodities, the large concentrated short position will buoy prices in silver relative to other commodities. In other words, the concentrated short position in silver, because it must be resolved, would serve as a risk-reducing factor in a broad commodity sell-off.